Are ETFs the next big financial scandal?

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Respected names are lining up against synthetic exchange traded funds

In May, Gillian Tett predicted scandal in the world of ETFs, but history is playing out faster than she guessed
Like the Collateralised Debt Obligations at the heart of the meltdown in the sub-prime debt market, Exchange Traded Funds are a useful innovation, on paper, and the sector has exploded. But ‘stodgy’ equity ETFs are giving way to increasingly exotic synthetic structures designed to boost returns. Because they’re thought to be safe, and they are outwardly transparent (they are traded on exchanges), risk managers like those at UBS supervising Kweku Adoboli don’t question what’s inside them.

Terry Smith warns (again) ETFs are not index funds, and they are being miss-sold to retail investors
Synthetic ETFs replicate physical assets using derivatives, rather than owning the assets. If the counterparty supplying the derivatives can’t pay, you have a problem. The mathematics of synthetic ETFs means they cannot guarantee to match the performance of the underlying asset and banks and hedge funds that short ETFs rely on creating the units to deliver when they close their shorts, which they may not be able to do.

Lex explains “Delta One” the name given to producing returns equal to those on a specific asset, by trading other assets
The ‘supposedly’ clever idea behind Delta One and synthetic ETFs is the bank keeps the extra profit above that needed to replicate the return of the underlying asset. Unfortunately it may have cost UBS $2bn, and led Jérôme Kerviel to rack up losses of €4.9bn at Société Générale in 2008. Delta One and synthetic ETFs work because banks believe they can use their algorithms to produce the same or better returns more cheaply, but it’s obvious they don’t fully understand what they are doing.

Money Observer has found someone prepared to say ‘it’s not the ETF that kills, people do’, or words to that effect
ETF related blow-ups at investment banks are the fault of rogue traders says Ben Johnson, director of European ETF research at Morningstar, although he does mince his words by admitting ETFs have inherent and potentially growing risks.

John Bogle, ‘father of the index fund’ feels like Frankenstein. No prizes for guessing the identity of his monster
Index funds, and specifically ETF’s which account for about half the value of index funds, are unequivocally an idea that is out of control. Bogle describes it as a good idea bastardised, which is financial jargon for turning a respectable financial instrument you would buy and hold forever into an instrument of speculation, in this case by concentrating on narrow corners of the market like gold, and employing leverage.

Comments

Hello Richard,

I fear your latest screen combining the F-score and PTBV is mistaken in the case of Ryanair which has equity of EUR 2,95b versus a mkt cap 4,48b; your screen shows a PTBV of 0.5 !

Hi Mark, thanks for your comment. I think you're right. I make its tangible asset value about EUR 2.9b.

Sharelockholmes, the data source quotes £7.6b - that's some exchange rate! I'll email and see if they can confirm there's an error in the data.

Richard.

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